A good, strong start

What happened?

In its much-awaited first rate cut of the post-pandemic economic cycle, the FOMC cut the Fed Funds rate by 0.5 percentage points to 4.75%–5.0%. The decision to cut was taken as a given, but the controversy was whether to cut by a quarter point or half point, with the market divided in its expectations between the two. The Fed took the decision to make the more aggressive move. Chair Powell went so far as to describe the move as “a good strong start.”  

Chair Powell indicated that the move does not reflect a belief that the committee is behind the curve but instead is a reflection of their intention not to fall behind the curve going forward. The key quote from the Chair is “the economy is in a good place and our intention is to maintain the strength that we currently see in the economy, and we will do that by returning rates from the high level to a more normal level over time.” They view this cycle as a “recalibration” or a “normalization” rather than something that is designed to stimulate the economy. It’s a reduction in restriction, not the addition of stimulus.

Looking ahead

Much more important than the size of the cut is the outlook for rates over the medium term. We know the path is downward, but at what rate and to what level?

The Fed’s dot plot, and Chair Powell’s remarks both suggest that the committee does not feel particular urgency to cut rates aggressively despite the recent 50 bps move. The median dot suggests that 25 bps cuts are likely at each of the Fed’s next two meetings, followed by quarterly 25 bps cuts thereafter with the policy rate not returning to the Fed’s estimate of neutral until early 2026.

Their other forecasts remain optimistic, with GDP growing around 2% per year for each of the next four years and the unemployment rate stabilizing at 4.4%. If the FOMC is right that they can normalize growth and the labor market around those levels, then they’ll be right to move slowly with interest rates.

Our forecast of GDP growth is more negative than the Fed’s, with the expectation that GDP growth will be closer to 1% than 2% next year—that leads to our expectation of more easing than the Fed’s dot plot suggests. That puts us at 2.75%–3.0% short-term rates by year-end 2025, a half point lower than the Fed’s expectations. We do not think the Fed is behind the curve or that a recession is in the offing. They appear to be in good position to respond to incoming information. Furthermore, with a high starting point, they have space to move quickly and sizably if needed.

In his press conference, Chair Powell indicated that the Fed has been rewarded for patience during this cycle and that guides their sense of how to proceed from here. He said repeatedly that “there is no sense that the committee is in a rush” to get to neutral. On a forward basis, they remain data dependent but not data point dependent: they are not going to respond to every data release but to the evolution of the data over time, as they have done to good effect for the last several quarters.  

The key variable to monitor is the labor market, and the analytical issue is the difference between the level of the labor market (strong) and the trend (weakening). The Fed views the labor market as roughly in balance at this stage—they are taking more information from the level than the trend. That said, if the weakening trend continues such that the level is no longer solid, the FOMC will be prepared to move more quickly; the Fed “neither seeks nor would welcome” a weaker labor market.  

The Fed does not appear to be on the cusp of ending QT. The balance sheet will continue to shrink for the time being. Chair Powell noted that the shrinking of the balance sheet thus far has been accomplished by a reduction in the Fed’s reverse repo facility rather than a decrease in reserves, which matter much more to the economy. Until the reverse repo facility is in equilibrium and reserves start to decrease, QT is likely to continue.